How To Pick Stocks, According To Warren Buffett

How To Pick Stocks, According To Warren Buffett

When seeking advice on stock investments, who better to get advice from than Warren Buffett? He is arguably the greatest living investor to date, with a true zero-to-hero story that is nothing short of inspiring. He bought his first stock when he was just 11 years old and through his hustle, he worked his way up to become one of the world’s wealthiest people.

In 2019, Buffett’s net worth was a whopping $80 billion. He also he has multiple companies to his name; 11 of which sit at the top of the Fortune 500 list.

Many individual investors, including his own wife, yearn for his knowledge on how to pick stocks. However, Buffett’s investment strategy isn’t as clear-cut as one may think. In a letter to his shareholders where he addressed his own mortality, Buffett gave instructions to the trustee he appointed to manage his estate for his wife:

“My advice to the trustee could not be more simple. Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, individuals—who employ high-fee managers.”

Clearly, Buffett doesn’t believe in “high-fee managers.” He doesn’t even suggest his trust hold stock in his own company, Berkshire Hathaway. Instead, he puts his faith behind the S&P 500 index fund, which is a type of mutual fund that consists of the 500 largest public companies in the US. He believes in it so much that he once bet $1 million that the S&P 500 would eventually outperform select top hedge funds.

Of course, keep in mind that everyone has their own ideas on how they’d like to invest their money, so just because it worked for Warren Buffett, doesn’t necessarily it will work for you. Still, his advice is definitely something to consider if you’re looking to explore your options.

Portfolios versus Value Investing

Buffett’s backing of the S&P 500 may come as a surprise to some, considering that his own company was built on investing in individual companies. Berkshire Hathaway’s portfolio consists of billions of dollars worth of stock investments in companies like American Express, Coca-Cola, and Wells Fargo. Such a portfolio follows a strategy called value investing, which focuses on a company’s intrinsic value while ignoring market fluctuations. This means Buffett’s team is looking for companies they believe have a competitive market advantage and a higher true value than the current stock.

That said, this method of picking individual stocks only works for Buffett’s team because they manage billions of dollars and can influence the performance of companies. In this way, they have some sway in the intrinsic value of the companies they invest in, whereas individual investors, who typically work within the thousands range of dollars, don’t have the same influence; nor will they be able to soften the blow of any losses that may occur.

The Advantages of Index Funds

Index funds offer individual investors many advantages over picking stocks. Firstly, index funds offer instant diversification, as it allows you to invest in 500 companies at once. It will take a much longer time (and quite some money) to diversify a portfolio if you choose to buy stocks individually.

Secondly, the 500 companies that comprise the S&P 500 are the top performing companies in the U.S., and thus they offer a pretty good snapshot of the state of the U.S. economy as a whole. Generally speaking, these companies are relatively stable, so they are great for the long haul.

Thirdly, it is easier to manage index fund shares. When you invest in individual stocks, investors are always having to decide when to buy and sell, and oftentimes they anticipate the market wrong and proceed with the transactions at a disadvantageous time. With index fund shares, investors can just follow a time-tested schedule of buying so they don’t have to look too much into the guessing game.

Lastly, the buy-and-sell dynamic that comes with choosing individual stocks has trading fees and commissions attached, so that is an additional expense to factor into your investment. In comparison, most fund firms allow access to their S&P 500 index funds for no fee at all.

Structuring a Portfolio

To build a portfolio based on the “very low-cost S&P 500 index fund” that Buffett mentioned in his letter, individual investors have a variety of fund options to choose from. A good one to start with is the Vanguard S&P 500 ETF (ticker symbol VOO) or the Admiral Shares S&P 500 mutual fund (ticker symbol VFIAX). Keep in mind that the latter will have a $3,000 minimum investment requirement.

As an additional investment, you can also choose to invest in short-term government bonds. The Vanguard offers its own Short-Term Government Bond ETF (ticker symbol VGSH), as well as Admiral Shares short term bond mutual fund (ticker symbol VSBSX), which also requires a $3,000 minimum investment.